Standard & Poor’s and Other Ratings Agencies Must End Their Power Trip

The ratings agencies’ ability to jeopardize the well-being of billions of people should be ended, says Zachary Karabell.

01.11.12 11:55 PM ET

In early December, the ratings agency Standard & Poor’s placed all 15 Eurozone countries under what it calls “negative credit watch.” Typically, that means there is an even possibility that it will downgrade the credit of these countries within 90 days. Nearly half that time has elapsed, which means that there is a considerable chance that within days, S&P will do for Europe what it did for the United States last summer and cut ratings.

The other two main agencies haven’t been silent. Fitch yesterday issued a statement saying that Italy was at risk, and that the European Central Bank had to take a more active role to prevent Europe from spiraling back into crisis and imperiling the global financial system. Both Fitch and Moody’s have indicated that there soon may be a downgrade of France, which has until now been a bulwark sustaining whatever remnants of a system still exist in the Eurozone.

It’s possible that the swirl of rumors and expectations of imminent downgrades will not materialize. Others believe that the sharp spike in interest rates of Italy in the fall, along with banks hoarding cash everywhere in Europe and indeed around the world means that markets have already anticipated downgrades and that when they come, it won’t much matter. That would be nice. It’s also quite possible that a series of downgrades will send already shaky global financial markets over the edge, setting off a chain reaction of mistrust and flight away from European debt and toward U.S. Treasuries that will send Europe decisively toward depression, the United States into recession, and the rest of the world into fear.

There is only one rational solution to the looming threat posed by the ratings agencies: they should stop rating sovereign debt. Cease and desist. A self-imposed restraining order. Why do they even rate government debt at all? The finances of governments are hardly secret. Anyone with a mind, an interest, or a need can do their own due diligence and analysis about whether the finances of Greece, Italy, the United States, Brazil, India, France, or any other of the nearly 200 nations in the world are too risky or safe or somewhere in between. There is no reason to pawn off that task to a few employees of three private companies, and doing so creates a ticking-time-bomb risk if those agencies act too quickly, allow their own biases to color the analysis, or act too late.

We went through one round of this last summer, when S&P reacted to the game of chicken over the debt ceiling in Washington by cutting the U.S. credit ratings one notch. The ad hominem comments of S&P about its discomfort with the gridlock of the U.S. political system struck some as wise analysis. It struck me as grand overreach, and this current move to pass judgment on the European economic system may trump that decision last summer in the annals of absurdity.

To be clear, the absurdity is not the analysis per se. The observation about the U.S. system was hardly controversial, and the warnings about the lack of coordination among Eurozone countries, rising rates, looming recession, and lots of debts are likewise obvious. The problem is the weight accorded to the decisions of three private agencies, and their ability to jeopardize the well-being of billions of people.

The power of the ratings agencies imperils the stability of the international financial system. There are no more than a few hundred people at these companies whose focus is on sovereign debt. They may all be skilled, highly trained, well meaning, competent—may be. But even if they are, resting the stability of a system that impacts billions on the shoulders of unelected, for-profit executives at three private companies is both disturbing and foolish.

The countries and governments of the Eurozone have been stumbling for the past 18 months to find a way to contain the debt implosions of the peripheral countries of Greece, Ireland, and Portugal. Recently, they have confronted the larger and more challenging issue of Spain, Italy, and the many German and French banks that hold those debts. Their efforts may be lacking, but the problems, the risks, and the need to find solutions are hardly secrets. Analysts and officials from every central bank in the world and every finance ministry and treasury department, as well as analysts and executives from every major financial institutions ranging from Chinese insurance companies to Brazilian fund managers, also have been playing out various scenarios and trying to assess risks.

Why then do markets, governments and media place such emphasis on what three ratings agencies say? Over the past half-century, the ratings of these independent agencies have been written into international banking regulations, pension fund guidelines, and investment protocols. In essence, a system of dependence was created, whereby multiple players simply passed on responsibility for assessing risks to these agencies. That was no small reason for the debacle that led to the credit and financial crisis of 2008 that the world has yet to move on from.

The buck-passing that led to the rise of the ratings agencies may be explicable, but in the realm of sovereign debt it is not tenable. The costs of these companiesa making pronouncements from on high is simply too great in a world where too many players are scared and unsure, and where those pronouncements trigger panicked or falsely confident reactions. Large pension funds with hundreds of billions of dollars, whether the California teachers fund or the state of Texas, sovereign funds ranging from the government of Norway to the city-state of Singapore and major financial companies shouldn’t need or depend on the analysts at a handful of ratings agencies. Large banks and insurance companies, especially European ones, shouldn’t be forced by regulators to adjust their holdings of French or Italian debt based on what the American company Standard & Poor’s says about those bonds. And governments themselves shouldn’t tailor their policies in order to avoid damaging decisions from the ratings cabal.

Here is an unequivocal case where market participants, including governments, should make the call. They should determine what the risks are, and what risks exist other than fear of what the agencies decide. If too many buyers are worried about Italian debt, they will demand higher rates, whether S&P acts or not. Ditto for any country in the world.

These agencies are flush with business. Their health and profitability don’t rest on passing judgment on sovereign debt. They could step aside in the sovereign ratings game without imperiling their own profit. Why they should even be profiting from such ratings is another equally troubling issue. But what an astonishing act of public service with limited business costs it would be if the three main agencies decided that their own long-term credibility as well as the global public good demanded that they simply cease and desist from rating governments. Let publics do that at the polls, and markets do that every day. Let the media do that in its global and noisy echo chamber. We will all be better for it. And if they do not, then at the least, let us do ourselves a service: ignore what they say and move on.